Davita: A Cheap Non-Cyclical

Davita owns the largest network of dialysis clinics in the U.S. The company caught my eye because Berkshire Hathaway owns 34.4% of shares and trades for less than ten times 2020’s (pre-pandemic) free cash flow. Upon further inspection, Davita has a lot of the characteristics I look for in a business:

• Simple, predictable, and profitable

• Replication mode

• Duopoly

• Non-cyclical

• Consistent share repurchaser

• Low valuation

What Is Dialysis?

Dialysis artificially removes toxins, fluids and salt from the blood of patients with End Stage Renal Disease (ESRD).

ESRD is also known as kidney failure. ESRD patient’s kidneys cannot filter their blood. Left untreated, ESRD is fatal. Diabetes and Hypertension are the leading causes of ESRD, contributing to 2/3rds of incidences. Approximately 550,000 Americans have ESRD.

ESRD has no cure. There are two treatments: a kidney transplant or dialysis. Kidney transplants are hard to come by (lack of donors) and not suitable for all patients. There are currently about 100,000 people on a waiting list for kidneys. Most ESRD patients undergo dialysis. They require dialysis three times per week for approximately 3.5 hours per session for the rest of their lives. On average, ESRD patients live for three years.

There are two types of dialysis: in-center hemodialysis and at-home peritoneal dialysis. 13% of Davita’s patients are at-home, which is slightly better than the national average of 12%. Abroad, at-home dialysis is much more common: 56% in Guatemala and 85% in Hong Kong.

In-center hemodialysis patients receive dialysis at a Davita clinic. Clinics have a chair, entertainment, and artificial kidney machine. Staff include approximately 5 nurses, 8 techs, a social worker, a dietitian and a nephrologist.

Most of Davita’s clinics also support at-home peritoneal dialysis. There are two types of peritoneal dialysis.

• Continuous ambulatory peritoneal dialysis (CAPD) introduces dialysis solution into the patient’s peritoneal cavity through a surgically placed catheter. Toxins in the blood continuously cross the peritoneal membrane into the dialysis solution. After several hours, the patient drains the used dialysis solution and replaces it with fresh solution. This procedure is usually repeated four times per day.

• Continuous cycling peritoneal dialysis (CCPD) is like CAPD, but uses a mechanical device to cycle dialysis solution through the patient’s peritoneal cavity while the patient is sleeping or at rest.

The benefit of in-center dialysis is access to professional staff who take charge of the patient’s care. The downside is that the patent will spend about 12 hours per week at the clinic.

The benefit of at-home dialysis is a more flexible lifestyle. The downside is that the patient is largely responsible for their own care, including inserting and removing large needles and avoiding infections.

Most at-home patients begin dialysis at a clinic before gaining the confidence to do it themselves at home. At-home patients still visit the clinic twice a month for check-ups and to buy supplies.

Who Pays For Dialysis?

Dialysis is expensive. Ryan McDevitt, a Duke economist, explains:

Each patient, it’s costing us about $100,000 a year to treat. We’re talking over $30 billion a year in Medicare spending. It’s 6 to 7 percent of Medicare’s overall budget, and it’s almost 1 percent of the entire federal budget, which to me is just a staggering statistic. Every $100 I send in taxes, one of it’s going to pay for dialysis.

Medicare, the federal health-insurance program for older Americans, pays for most dialysis treatments. Medicare usually kicks in at age 65. However, Medicare will cover dialysis to treat ESRD at any age. Treatment for A.L.S. (Lou Gehrig’s disease) is the only other exception to Medicare’s 65+ rule.

There is one catch. A patient with commercial insurance coverage must wait 33 months before transitioning to Medicare. This has important consequences for Davita.

Bargaining Power

Commercially-insured patients make up 10% of Davita’s customers but virtually 100% of its profits. Davita breaks even on the 90% of its patients covered by a government insurance program.

Bargaining power explains why. Since the Federal government pays for the vast majority of dialysis treatments, they have huge bargaining power. Medicare sets a reimbursement rate and Davita can either take it or leave it. Though Davita doesn’t make money on these patients, they help the company achieve scale efficiencies.

Davita makes all its money from its commercially-insured patients because it is able to charge them four times the Medicare rate. Davita is able to charge commercial insurers so much more because the dialysis industry has consolidated into a duopoly. Combined, Davita and Fresenius have a 75% market share, split approximately equally. This is much more consolidated than anywhere else in the healthcare industry. For example, according to Morningstar:

The top 10 hospitals claim only about 15% of the hospital market and the top independent reference labs (LabCorp and Quest) cumulatively claim less than 25% of the lab services market.

Davita and Fresenius’s large market share give it strong bargaining power with commercial insurers. Davita has has long-term (5 year) contracts with most of the largest insurers, which makes its revenues relatively stable and predictable.

Low Cost Producer

There are, generally speaking, two types of businesses I want to own.

The first are businesses with pricing power, like Altria, Apple, and Ferrari. Their brands differentiate their product, make their customers believe that no close substitutes exist, and produce pricing power.

The second are low cost producers of undifferentiated products, like McKesson and Progressive. Low-cost producers differentiate themselves by offering lower prices than their competitors can afford to match.

Davita is best understood as a low-cost producer even though dialysis isn’t a pure commodity. Quality of care matters when lives hang in the balance. But the quality of care at Davita isn’t much different than at Fresenius or a hospital. Patients choose a clinic based on convenience of the location and referral from their doctor. Davita has relationships with about 70% of the nephrologists in America, which provides a strong referral pipeline. This is a hard-to-replicate moat.

Commodity producers are usually price takers, not price makers. That’s true of Davita, which has to take whatever price Medicare decided to set. While Davita negotiates higher prices with commercial insurers, it doesn’t have enough bargaining power to price dramatically higher than inflation. Davita is no See’s Candy or Ferrari.

Davita’s average revenue per treatment is $350. A similar treatment at an acute-care hospital would cost many multiples of that. So, insurers and Medicare alike have a financial incentive to steer their patients towards outpatient clinics like Davita and Fresenius operate.

Davita and Fresenius keep costs low by leveraging their scale. Davita pools it’s buying power across all of its clinics to get deals on pharmaceuticals and other supplies. It also shares operational know-how across clinics to reduce labor.

Medicare reimbursement rates are a perpetual worry for Davita and the dialysis industry. However, Davita’s low cost structure mitigates this risk. If Davita has industry-leading scale and the lowest cost structure and still only breaks even on Medicare dialysis, then sub-scale mom-and-pop operators must lose money. If Medicare further reduced its reimbursement rates or doesn’t increase them with inflation (nurses need annual raises, rent goes up, pharmaceuticals get more expensive), then mom-and-pop operations will go under.

In that scenario, Davita and Fresenius would acquire these unprofitable clinics at bargain prices. As a result, the dialysis industry would become further consolidated and Davita and Fresenius will gain more bargaining power and possibly earn higher margins.

Ted Weschler’s Three Filters

Warren Buffett hired Ted Weschler to invest on behalf of Berkshire in 2011. Before, Weschler managed Peninsula Capital. Between 2001 and 2011, Peninsula had 20-40% of its portfolio invested in Davita. Upon started at Berkshire, Berkshire started buying Davita. So it is safe to assume that Davita is Weschler’s position.

Weschler says he has followed the dialysis industry for over thirty years. He told CNBC has three filters for investing in healthcare companies:

• Does the company deliver a better quality of care than somebody could get anywhere else?

• Does it deliver a net savings to the healthcare system because of the efficiency the company provides?

• Does it earn high returns on capital, predictable growth, shareholder friendly management?

Davita passes all three filters.

Quality of care varies by clinic, but, on average, Davita scores well. At least according to the government’s criteria. The Centers for Medicare & Medicaid Services (CMS) launched its Five-Star Quality Rating System for dialysis centers in 2013. The Five-Star Quality Rating System is a composite of two separate scores:

• Quality of Patient Care Star Rating

• Patient Experience Star Rating

According to Davita:

In 2020, DaVita outperformed the rest of the industry combined with a higher percentage of centers rated three-, four- and five-stars for the seventh year in a row.

Nevertheless, it is easy to find negative articles about Davita and Fresenius clinics. Many abhor Davita’s profits. They’d rather see an even higher quality of care, such as having even more staff at each clinic, and fewer profits. The balance between profits and quality of care is delicate and tricky. I don’t know the “right” answer. But it is clear that Davita offers at least industry-standard care and likely industry-leading care, despite its profits.

That Davita has industry-leading scale and industry-leading quality of care yet only breaks even on Medicare dialysis tells me that Davita provides a net savings to the healthcare system. No one is providing so much for so little. Sure, critics will always want more. And Davita should always aspire to improve. But the fact remains that they currently offer the best care for the least money.

So long as Davita maintains this value proposition, their profits should be durable and their market share should expand.

Forward Returns

Davita’s forward returns are a function of three key variables: number of treatments, revenue per treatment, and buybacks.

Pre-pandemic, Davita was growing patient count about 2% per year. Covid hit Davita’s patients particularly hard and 2021 treatment growth swung to -2%. The impact of excess mortality is cumulative, so 2022’s growth will continue to be under pressure.

Management expects that the present’s excess mortality will be followed by a period lower mortality. They think patient growth could accelerate 6% per year over the next several years. If 2022 is the bottom, then Davita could growth faster through 2025. However, it’s anyone’s guess when Covid’s excess mortality impact subsides.

As Davita saturates the U.S. with clinics, its growth has slowed. Looking through the pandemic, I wouldn’t expect Davita to grow faster than low single digits.

Source: Eagle Point Capital, Data From 10-Ks

Revenue per treatment is driven by Davita’s mix of commercial and government payers and Medicare reimbursement rates. Medicare reimbursement rates have been nearly flat for the past several years, but are set to resume their long-term annual increases. On balance, management thinks revenue per treatment will grow 0.5-1.5% per year.

Davita thinks cost per treatment is likely to grow 1-2%, which implies contracting margins. However, they think they’ll be able to offset about half of the cost per treatment growth through efficiency gains, protecting margins.

On balance, that places Davita’s long-term growth in the 3-5% range. That’s not fast, but it is predictable and non-cyclical. More importantly, Davita won’t need to retain much capital to fund this growth (ROE is > 50%), leaving plenty of room for buybacks.

Davita’s leverage is currently right in the middle of its target range of 3.0-3.5x EBITDA. Though this is high leverage by most standards, it strikes me as reasonable for such a steady business. Davita has no major debt maturities for three years.

Davita has historically used its strong free cash flow to buy back its own shares. Shares outstanding have fallen at an 11% CAGR since 2015 and declined 40% over the last 4 years. Going forward, buybacks will probably approximate free cash flow. To be conservative, I’ll assume they amount to 80% (2015-2017’s average).

Source: Eagle Point Capital, Data From 10-Ks

In 2020 Davita produced $1.3 billion of free cash flow. Today the company is worth $11.2 billion. That’s just 8.6x 2020’s free cash flow. At this valuation, 80% of free cash flow spent on repurchases would produce a 9% yield and 10% EPS CAGR.

However, this is an unusually low valuation for Davita. According to Value Line, the stock’s median P/E is 17x. At that valuation, 80% of free cash flow will retire 4.7% of shares and produce a 4.9% EPS CAGR.

Adding this to Davita’s business growth rate of 3-5% gets us to 8-10% annual forward returns. This is after the stock re-rates from 9x to 17x P/E. A re-rating like that over five years would add 13.5% CAGR to returns and bring the five -year CAGR close to 20%. A 17x P/E might be on the high side for a low-single-digit growth business, but some multiple expansion is warranted. If the stock doesn’t re-rate, a 10% buyback yield will push the company’s EPS CAGR to around 15%.

Summary

Davita is a simple, predictable, profitable business that’s in replication mode, is part of a duopoly, and has a durable low-cost advantage. It trades at a historically low valuation because the pandemic temporarily slowed its growth. However, the pandemic will eventually subside and Davita’s growth will revert towards its historical trend. Investors can take solace in the company’s low valuation knowing the company is capitalizing on the opportunity to retire shares cheaply.

Davita’s business should grow at 3-5% over the long term. Buybacks or a multiple re-rating will likely boost earnings per share well into the double digits. Management expects to grow EPS 8-14% per year, which looks possible.

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